A breakdown of COST

Costco Wholesale Corporation (Ticker: COST) has seen a year-to-date return of 44%, not bad for 2019. But before you rush to buy the stock while trading at near-all-time highs, let’s take a deeper dive into the business itself.

Costco is the premier low-cost buyer and seller of products that the public has an ongoing need for, giving the business a durable competitive advantage. The company has 550 warehouses in the U.S. and an additional 235 international locations. I have personally been to a Costco warehouse in South Korea and they operate exactly the same as warehouses here in the U.S. They have done an outstanding job replicating the business model across markets. In August, Costco opened its first Shanghai location with 200,000 memberships in the first 5 months. A second location is in the works and the company plans to target China over the next several years.

Quite the run

Costco operates a membership model and it seems to be working. In 2019, the company had a 91% renewal rate domestically, and 88% internationally. Costco also has a private label, Kirkland, that is a powerhouse in the world of retail. Kirkland makes a variety of products that have proven popular over the years. In fact, Kirkland sales reached $39 billion in 2018 while Kraft Heinz only had $26.3 billion, demonstrating that its investment in the private label has paid handsome dividends. Speaking of dividends, the company has had 15 years of consecutive growth of dividend payments to investors, making the added cash flow just another selling point along with the appreciation of the stock.

Warren Buffett knows all too well about the appreciation of the share price over the past 19 years. In 2000, after a bleak earnings announcement, the share price fell 37%, making it a prime candidate for Berkshire’s portfolio. In the second quarter of 2000, Berkshire bought 24 million shares at approximately $30 per share. They don’t hold quite as many shares currently; however, since their initial investment, they’ve had a 931% return, compared to the S&P 500 return over the same period of 115%. Costco is trading at $295 today. So why not buy now then? Let’s keep analyzing the business.

Key metrics

Over the past 5 years, net income has gone from $2.3B to $3.6B with gross profit increasing more than $4 billion over the same timeframe. Costco reported Q1 fiscal 2020 earnings of $36.24 billion, up 5% year over year. The past 12 months yielded a 26% return on equity. Walmart, by comparison, has returned just 6%. Costco’s biggest competitor is Sam’s Club, which accounts for 11% of its parent company’s (Walmart) revenue. Walmart has Costco beat on gross profit margins, a figure arrived at by taking gross profit and dividing it by total revenue. Typically, a gross profit margin of 40% is a strong indication that the company is operating with a competitive advantage. Costco’s margin is 13% compared to Walmart’s 24%. Still, Costco is expanding aggressively into international markets, while Walmart has largely stayed domestic. Costco is also competing in the ecommerce and delivery spaces, offering same-day deliveries to customers within a 20-mile drive from any Costco warehouse.

Costco's gross profit margin of 13.0% is less than Walmart's 24.8%. However, both companies' net income margins are flat, with Costco at 2.4% against Walmart's 2.8%. Selling, general and administrative costs as a percentage of gross profit have hovered around 75% for the past five years, with companies such as Coca-Cola and Procter & Gamble routinely spending around 59% and 61%, respectively.

Walmart’s debt dwarfs Costco’s, making the investment somewhat safer if an economic downturn were to hit in the coming months. Servicing the debt of $77 billion is a much tougher task than servicing the debt of $7 billion. In 2019 alone, Walmart’s interest expense was $2.4B, compared to Costco’s $150M. Clearly, Costco is well positioned if the business sees decreases in revenue over the next couple years.

In closing, Costco serves a need that will most likely not go away anytime soon. People will still need (and want) to buy in bulk to create economies of scale for products and services that they see great value in. When you’re selling $5.3 million pumpkin pies annually, you must be doing something right. We see tremendous growth coming from the company in years to come, both with international expansion and ecommerce. As of just last year, Costco’s percentage of total net sales that comes from ecommerce was only 4%, so there’s a huge growth opportunity if the company can begin competing with Amazon on its delivery services; a formidable goal but one worth pursuing.

Buffett’s 10K Analysis

For years Warren Buffett has stayed away from the opinions of Wall Street in favor of the hard numbers one can find in a company’s financial statements. He’s rejected the inane complexity of New York City investment pundits for the serene simplicity of Omaha. He has used his knowledge of accounting and finance to uncover the durable competitive advantage of certain companies that have made him tens of billions over his career. Buffett, unlike his mentor Benjamin Graham, is not merely a value investor; although, if a value presents itself he certainly won’t shy away from it. Buffett and his Berkshire Hathaway (currently #4 on the Fortune 500) have taken a different approach to Graham and invested in great companies that don’t necessarily trade below book value. He’s been quoted as saying “it’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.” Whereas Graham would hold the stock in a company for a matter of months or years, Buffett invests for the long-run, often holding the stock for decades.

In his search for a company with a durable competitive advantage, Warren digs deep into the financials, heading straight for the 10K, where he can ignore all the fluff often found in the Annual Statement. The criteria by which he selects his next big winner is limited to certain key parameters which we will highlight in this article.

Uniqueness of product or service offering

Warren starts with companies that sell a unique product or service. Think Coca-Cola, American Express and Moody’s. Each one sells something unlike any other company. The brand names alone tell a unique story. American Express, for example, is an exceptional company that goes above and beyond for its customers. Its online platform is user-friendly, efficient, and safe; giving its customers a sense of ease and peace of mind. Coke is consumed literally everywhere on the planet, making its durable (think 120+ years in business) competitive advantage unrivaled.

One of Buffett’s favorite investments is Moody’s with Berkshire owning 13% of the outstanding shares as of March, 2019. The economics of selling a unique service like Moody’s, which is a provider of credit ratings, economic research, data and analytical tools, and other software solutions is a great business as it isn’t capital intensive, nor does it have inventory or other product-related costs. The margins on a unique service such as Moody’s are thus much better than a company offering a great product, generally speaking.

Buffett’s long-time friend and business partner, Charlie Munger, sits on the board of another Berkshire favorite: Costco. Being the low-cost seller of products that the public has an ongoing need for has done wonders for Berkshire’s shareholders, Costco’s investors, and the public at large. The average ticket of Costco shoppers is much higher than the average ticket of other retail stores including Kroger and Wal-Mart. The average membership holder at Costco spends $2,500 annually, and it is this consistency that draws Buffett to an investment. When the leadership at Berkshire evaluates a potential investment, they’re looking for consistency across the board. Does it consistently produce earnings? Does it consistently grow revenue? Does it consistently carry little or no debt? Volatility is not the friend of Warren’s. He’s looking for durable businesses that stand the test of time in good markets or in bad. Whereas most investors will attempt to time their purchases of a business, Buffett buys in any environment if the economics of the business are sound. In other words, he doesn’t let the ebbs and flows of the market keep him from investing, he simply goes where the great businesses are found.

It’s all about the margins

Buffett starts with revenue and the cost of earning that revenue. Where are the earnings coming from? What does that trend look like over time? How much money does it take to generate the revenue? In attempting to weed through all the mediocre businesses out there, Warren takes a hard look at the gross profit margin of the business. He has found that excellent companies have consistently higher gross profit margins than companies that don’t show quite as high margins. Coca-Cola has produced margins of 60% or better year in and year out. Moody’s comes in at 73%, consistently. Having the freedom to price products and services well in excess of its cost of goods sold is what drives the gross profit margin of a company that has a durable competitive advantage. As a general rule, 40% or better is what Warren looks for when he starts his search. 20% or lower would tend to indicate that a company is in an intensely competitive industry and therefore does not have an advantage to price its products or services to allow these high spreads between revenue and the costs associated with it. The search certainly doesn’t end here though.

A company can have a remarkable gross profit margin year after year, yet have high operating costs that eliminate gross profit and send investors like Warren to the exits. Among these operating costs are Selling, General & Administrative (SG&A) expenses that can run into the billions. The key is to look for SG&A costs that are consistent and absent of wild variations from year to year. Both Ford and GM saw huge variations in their SG&A expenses around the time of the Great Recession, sometimes running as high as 700% of gross profits, which translated into massive losses. So what is a respectable percentage of gross profit that goes to SG&A? There are always exceptions, but in general 30% of gross profit is said to be a good indication that management is handling expenses in a prudent manner. That said, SG&A expenses, even for companies that do show a durable competitive advantage can run as high as 80%. Anything north of 80% though, and the company is in jeopardy of losing money, especially after interest expense, depreciation, and income taxes.

Other operating costs that Buffett considers when looking for outstanding companies is Research & Development and Depreciation, the latter being ignored by the EBITDA types that seem to enjoy artificially inflating earnings by disregarding interest, taxes, depreciation, and amortization. Companies that must spend large sums on R&D are usually scrambling to come up with the next best product, therefore the inherent economics of the business are always at risk since the elimination of R&D spending would render the product obsolete at some point. Depreciation and amortization, according to Warren, are a very real cost of doing business. To ignore them by calculating earnings before these costs is a fool’s game whereby the wear and tear of capital assets is flat-out ignored. So what percentage of gross profit does Buffett look for? It depends, of course. Coke has traditionally had its depreciation expense run at around 6%. Anything north of 25% of gross profit is cause for concern and probably should be looked at in greater detail. Anything less than 10% is definitely something to write home about.

With depreciation, less is more. The same holds true with interest expense. Interest is reflective of the amount of debt a company carries on its books. The airline industry obviously would pay out much more in interest expense than a company making shampoo. As a rule, businesses that operate within the consumer products industry typically should pay out 15% or less of operating income. Banks and other financial institutions would likely have higher limits to this rule since borrowing and lending is the core business. Even then, interest expense as a percentage of operating income should be carefully examined. In 2006, Bear Stearns was reporting ratios of 70%; by late 2007 that number jumped to 230%. In 2008, the company was in such bad shape that it was acquired for pennies on the dollar by JP Morgan.

Net it out

Net earnings are another big (and obvious) factor in finding the next big investment for Berkshire. A consistent, upward trend is what’s important when it comes to net earnings. Warren tends to focus more on the overall earnings, as opposed to the per-share earnings that has Wall Street so enthralled. Share buyback programs will distort what’s actually happening if the per-share earnings is the primary focus. To that end, net earnings as a percentage of total revenue is another key metric that Warren looks at. The higher the percentage, the better. Given $1 billion of earnings on $5 billion of revenue or $10 billion of earnings on $200 billion of revenue, it’s the $1 billion that’s yielding 20% that wins in Warren’s eyes, over the 5% of $200 billion in revenue. Coke and Moody’s earn 21% and 31% on total revenues, respectively. Before GM went bankrupt it was earning 3%.

There are, of course, several other metrics that Buffett uses to produce the returns he has had over the past decades, but we’ll leave it here for now and end with one of our favorite quotes from Warren regarding simplicity: “There seems to be some perverse human characteristic that likes to make easy things difficult. The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective.” Sometimes it’s easier to look at only the numbers when making an investment, while tuning out the noise.

Jack Bogle: In Memoriam

I’ve never had someone famous write a letter to me. Then again, I’ve never really written a letter to anyone famous; that is until I wrote Mr. Bogle on March 7th, 2015. I had heard that he allocated several hours every week to reading and responding to letters. 16 days later, I received a letter from arguably the greatest positive influence on the investment industry to ever live. It read as follows:

“I’m happy with my role in building a better mutual fund industry.” What a role it was. How humble is that statement. If there were three character traits that set Jack Bogle apart from the rest, they would be humility, integrity, and contentment. I’ll start first with the last trait.

Being content and having enough

Bogle could’ve been a billionaire several times over. He chose not to be. I don’t know of a single person who would opt for tens of millions instead of tens of billions. But Bogle did. He wasn’t really motivated by money. He was motived by purpose. He was motivated by service. And he was unwavering in his convictions right to the end.

I sensed back in 2015 that he would only have a limited numbers of years left, so I thought I’d reach out to a man I admired to see if the rumors were true about his handwritten letters. They were. Why I doubted him for a single second was more of a personal fault on my part more than anything. Never underestimate the power of good people out there. Not merely because he writes back to his Bogleheads like myself, but because he devoted his life to good things: good family, good work, good purpose, good people surrounding him, and an all-round good life.

Bogle was content, at least with the financial rewards he received. He was never really content with the investment industry as a whole though, working tirelessly until the end. He wrote an entire book on the topic of contentment called Enough. It’s classic Bogle. He starts the book with the following statement in the introduction: “The rampant greed that threatens to overwhelm our financial system and corporate world runs deeper than money. Not knowing what enough is subverts our professional values. It makes salespersons of those who should be fiduciaries of the investments entrusted to them. It turns a system that should be built on trust into one with counting as its foundation. Worse, this confusion about enough leads us astray in our larger lives. We chase the false rabbits of success; we too often bow down at the altar of the transitory and finally meaningless and fail to cherish what is beyond calculation, indeed eternal.”1

False rabbits of success. Bogle’s net worth could’ve exceeded that of the Johnson family that founded Fidelity Investments with nearly ten billion in their coffers, but Bogle was content with what he had. Seven years ago he said that his only regret about money was that he didn’t have more to give away. He regularly gave half his salary to charities. He forfeited billions in pursuit of a company whose structure was fundamentally different than the Schwab’s, BlackRock’s, and Fidelity’s of the world. Vanguard was created as a privately held company where its fund investors actually owned the company, thereby virtually eliminating any conflict of interest. In contrast, many fund companies are publicly owned companies attempting to maximize share price for their shareholders at the expense of its fund investors. They rob Peter to pay Paul. They have to, there’s no other choice. In order to increase share price, they must create value by driving up the earnings per share. But in order to increase earnings, they must charge the everyday fund investors more to invest. Redistribution is the name of the game. Bogle led the charge to fix all of that. Today, Vanguard has nearly 5 trillion of assets under management (AUM) and is one of the largest fund companies on the planet.

On having enough, Bogle said this in his eponymous book: “But the question remains: What are the things by which we should measure our lives? I’m still searching for the ultimate answer to that question. But I know that we can never let things as such—the material possessions we may come to accumulate—become the measure of our lives. In a nation as rich with material abundance as ours, a cornucopia of things almost beyond measure, it is an easy trap to fall into. Two and a half thousand years ago, the Greek philosopher Protagoras told us that “man is the measure of all things.” Today, I fear, we are becoming a society in which “things are the measure of the man.”

Righteous without being self-righteous

I won’t take credit for this play on words. I had read it somewhere else after news came that Bogle had passed. He was righteous in his thought processes and his purpose without showing a shred of being self-righteous. He was a man of his word, he led by example, and he was revered by Bogleheads, Vanguard employees, and the investing public who benefited from his commercialization of the index fund.

There’s no shortage of investing knowledge Bogle left behind, but I believe his true legacy will soon become more about the person he was than on the things he did. He loved to write. He penned letters, wrote essays and speeches, and authored many books. The investing public will undoubtedly gain from his research, and many will be able to live much better as a result of his advice to invest early and often in low-cost, highly diversified index funds. To “stay the course” and as he wrote in his letter to me, to “press on, regardless.” Bogle was wise beyond his 89 years, living 14 more years than the average person with a heart transplant. He made the most of it with assertions and philosophical creeds that I’ll leave you with on commitment.

“Commitment and boldness—these are among the things that truly matter, the things by which we can measure our lives, the things that help turn providence in our favor. Their reach goes far beyond how we earn our living, for never forget that none of us lives by bread alone. The well-rounded life requires other commitments, too. These commitments begin with our families. Until we are committed, there is the chance to draw back, but once we commit ourselves to family, all sorts of things occur that might never have otherwise occurred. Each of us must decide for ourselves how much to focus on things, and indeed what things to focus on. But I know that each one of us can profit by some moments of quiet introspection about whether our lives are driven far too much by the accumulation of things, and not nearly enough by the exercise of bold commitment to our family, to our work, to a worthy cause, to our society, and to our world.”

1. Enough : true measures of money, business, and life / John C. Bogle